Companies have long used corporate inversions to reduce their U.S. taxes. Prior to 2004, the IRS was concerned that U.S. corporations that carried out inversion transactions could remove non-U.S. operations from the U.S. tax system and strip earnings by becoming subsidiaries of foreign companies (typically organized in low-tax jurisdictions). In 2004, the IRS implemented legislation, known as the "anti-inversion rules," to prevent these perceived abuses. With more regulations having come into effect on November 19, 2015, there are new areas to be mindful of when planning for corporate restructuring.
Inversion – general provisions
An inversion transaction consists of a plan or a series of related transactions resulting in a foreign corporation becoming a "surrogate foreign corporation" (and thus becoming subject to certain U.S. tax implications). An inversion has occurred if the transaction meets three criteria:
- a U.S. corporation or partnership becomes a subsidiary of the foreign-incorporated entity, or otherwise transfers substantially all of its properties to such an entity;
- the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 60 per cent or more (by vote or value) of the stock of the foreign-incorporated entity after the transaction; and
- the foreign incorporated entity, considered together with all companies connected to it by a chain of greater than 50 per cent ownership (i.e. the expanded affiliated group, or EAG) does not conduct substantial business activities in the entity's country of incorporation compared to the total worldwide business activities of the EAG.
The U.S. tax impact of an inversion is generally determined by the level of ownership of the foreign acquiring corporation immediately after the transaction – specifically, whether the transaction involves at least 80 per cent of stock ownership of the foreign acquiring corporation by the former shareholders of the U.S. corporation after the transaction. Also of importance is whether the transaction involves at least 60 per cent ownership, but less than 80 per cent ownership of such foreign acquiring corporation by the former U.S. shareholders.
In corporate inversion transactions in which the former shareholders of the expatriated U.S. corporation hold at least 60 per cent, but less than 80 per cent (by vote or value) of a foreign acquiring corporation, the foreign acquiring corporation becomes a "surrogate foreign corporation," and transactions are subject to "inversion gain" principles. Expatriated entities could be subject to recognized gain treatment for tax purposes on these "inversion gains" without the allowance of certain tax attributes such as net operating losses (NOLs), foreign tax credits, etc. to offset.
For inversions in which the former shareholders of a U.S. corporation hold 80 per cent or more (by vote or value) of the stock of the foreign incorporated entity after the transaction, the treatment for U.S. tax purposes is more straightforward. The foreign acquiring corporation is simply treated for all purposes of the Internal Revenue Code (IRC) as a domestic corporation in these 80 per cent identity transactions, and the shareholder-level toll charge (or inversion gain tax, as described above) does not apply.
According to a recently published IRS notice (Notice 2015-79), the IRS will be issuing new regulations to address the rules surrounding corporate inversions. Those regulations should affect the rules associated with most inversion transactions occurring on or after November 19, 2015, and are intended to close off the loopholes permitting corporate inversions that are inconsistent with the purposes of IRC Section 7874. A brief outline of the new regulations is summarized below.
Business activities not subject to tax
As noted in the "general provisions" section above, EAGs that have a substantial business presence in a foreign country are not subject to the corporate inversion rules. However, many of these foreign corporations operate in tax-free environments, either by the nature of tax legislation in the foreign country (e.g. criteria to determine residency), or due to the differences in tax treatment of certain types of entities between the U.S. and the foreign country. This could occur, for example, when the foreign entity is treated as a flow-through entity in the foreign country, but not in the U.S.
As such, under new regulations, the IRS will not allow EAGs to qualify for the exception for substantial foreign business activities unless that EAG is subject to tax in the foreign country.
New regulations will forbid the use of third-country acquisitions, as the IRS regards these as a method of disguising corporate inversions. These regulations will apply when the newly organized foreign entity acquires two target entities, one of which is a U.S. domestic entity. This type of structure reduces the ownership percentage of the former U.S. shareholders in the new parent company, thereby avoiding the 80 per cent threshold that would trigger the application of the corporate anti-inversion rules.
The new regulations will apply when all of the following criteria are met:
- the new foreign parent acquires a non-US corporation in a transaction related to the acquisition of the domestic entity;
- the foreign target's assets exceed 60 per cent of the gross value of the foreign group property (not including the domestic entity);
- the tax residence of the foreign parent differs from that of the foreign target corporation; and
- the former shareholders of the domestic entity hold between 60 per cent and 80 per cent of the foreign parent following the transaction(s).
If the above requirements are met, the stock of the new foreign parent corporation that was issued to the former shareholders of the foreign entity will be deemed "avoidance property" and thus disregarded in the calculation of ownership share. This would effectively bring up the ownership percentage of the former shareholders of the U.S. corporations to exceed 80% in many cases (as calculated under the "general provisions" principles described above).
Disqualified stock from avoidance property
As with the third-country transactions noted above, the IRS has included with these new regulations additional guidance for stock issued for purposes of avoiding the inversion regime. (Known as "disqualified stock," this is generally stock issued in exchange for certain liquid assets or non-qualified property.) Specifically, these regulations state that stock issued for any property transferred for the purposes of avoiding the inversion rules will be disregarded for the purposes of a so-called ownership fractions calculation, thus addressing attempts to dilute ownership for purposes of determining whether or not a transaction is subject to the inversion rules.
Definition of inversion gain
As noted above, inversion gains that result from corporate inversions may not be offset by NOLs, foreign tax credits, etc. With the release of the new regulations, the IRS has expanded the definition of inversion gains to include additional categories of income (e.g. income that results from subsequent transactions) as part of the inversion gain transaction.
Section 1248 transfers
Under IRC Section 1248, when a U.S. shareholder exchanges shares of a controlled foreign corporation (CFC) in a tax-free transaction, the shareholder may be required to recognize a deemed dividend generally equal to the earnings and profits of the CFC. The new rules address scenarios in which CFCs owned by "expatriated entities" are transferred under an inversion and may avoid the 1248 gain treatment. The new proposals would require that the difference between the fair market value of the CFC shares and its tax basis be included in the expatriated entities' taxable income. This could create numerous issues, including a mismatch of foreign tax credits due to timing of income recognition.
Cross-border transactions can make the U.S. economy stronger by enabling U.S. businesses to invest overseas, encouraging foreign investment to flow into the U.S. But these transactions should be driven by genuine business strategies and economic efficiencies, rather than a desire to shift the tax residence of the parent entity to a lower-tax jurisdiction simply to avoid U.S. tax. Thus, the IRS is taking steps to prevent any perceived tax avoidance incentives to transactions that qualify as tax inversions. These steps should reduce the ability of inverted companies to escape U.S. taxation.
More than ever, careful tax planning is crucial to ensure that an inversion transaction does not result in unintended tax pitfalls. For more details, contact your Collins Barrow advisor.
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