Canada: Avoiding Costly U.S. Tax Traps In Structuring Acquisitions Of U.S. Targets

The IRS recently released final Treasury regulations that are critical to determining when the U.S. inversion rules apply to a particular transaction. If applicable, the U.S. tax rules regarding inversions can have an extremely adverse impact on Canadian corporations that acquire or reorganize U.S. entities. Since the inversion rules can apply in unexpected ways, Canadian companies considering a cross-border acquisition or restructuring should work closely with their U.S. tax advisors to avoid unexpected problems with these rules.

Background

Congress enacted the inversion rules in 2004. These rules were targeted at U.S. corporations that were effectively relocating to lower tax jurisdictions to avoid or reduce the U.S. tax burden of a corporate group. In a typical inversion transaction, the shareholders of the U.S. corporation would contribute their shares in the U.S. corporation to a new foreign corporation (for instance, in Bermuda) in exchange for shares of the foreign corporation. Once inverted, the U.S. corporation was positioned to engage in other complementary transactions that were intended to enhance the U.S. tax savings to the corporate group. For example, the new foreign parent corporation would often acquire the U.S. corporation's foreign subsidiaries and possibly other assets, such as intellectual property.

In general, an acquisition by a Canadian corporation (Canco) will be subject to the inversion rules if:

(1) Canco acquires, directly or indirectly, substantially all of the assets of a U.S. corporation or partnership (U.S. target);

(2) Canco does not have "substantial business activities" within Canada; and

(3) the former shareholders of the U.S. target own at least 60% (by vote or value) of the stock of Canco.

As indicated in part (3) above, the extent to which former shareholders (whether they are U.S. or non-U.S. persons) of the U.S. target own (or are treated as owning) shares in Canco is critical in determining the consequences of the inversion rules. Specifically, if the former shareholders of the U.S. target own 80% or more of Canco's shares, the inversion rules will treat Canco, for all U.S. federal income tax purposes, as a U.S. corporation. This can have disastrous results, potentially rendering Canco subject to tax on its worldwide income in both the U.S. and Canada, with no apparent relief under the Canada-U.S. Income Tax Treaty. Additionally, distributions by Canco to Canadian investors would generally be subject to U.S. withholding tax. If the former shareholders of the U.S. target own less than 80% but at least 60% of Canco's shares, the inversion rules will not treat Canco as a U.S. corporation but will impose certain negative U.S. tax consequences on the inverted U.S. target.

Potential Traps

The Inversion rules contain a number of complicated rules for determining whether the 60% or 80% ownership tests are met. These detailed rules can apply in a variety of unexpected ways, as illustrated by the following examples:

  • Canco and a U.S. company (USco) form a new U.S. corporation as a 50/50 joint venture. If Canco and USco decide (even for perfectly valid business reasons) to contribute their shares in the U.S. joint venture corporation to a new Canadian holding company, this new Canadian holding company would be treated as a U.S. corporation under the inversion rules.

  • In order to list its shares on the TSX, the U.S. target forms a Canadian corporation, which offers shares to the public in an IPO on the TSX. Canco uses the IPO proceeds to purchase a majority interest in the U.S. target. The founding shareholders of the U.S. target exchange their old U.S. target shares for new Canco shares. Because the inversion rules would not count the shares issued in the IPO for purposes of the 60%/80% test, Canco would likely be treated as a U.S. corporation under the inversion rules despite its shares being listed on the TSX and even if the former USco shareholders have a relatively small interest in Canco.

The Final Regulations: Substantial Uncertainty Persists

The new Regulations, issued in Treasury Decision 9399 on May 20, 2008, finalize many of the computational rules that are essential in determining the ambit of the inversion rules. Even though these rules provide greater clarity in some respects, there is still substantial uncertainty regarding their practical application in many cases. In addition, language in the preamble to the Final Regulations creates more uncertainty. In particular, the IRS put taxpayers on notice that it intends to issue further inversion regulations to address three types of transactions. Importantly, the IRS has indicated that if a Canadian corporation acquires substantially all of the assets of a U.S. target that is in bankruptcy and the creditors of the bankrupt target receive at least 60% of the stock of the Canadian acquisition company, the transaction may be subject to the inversion rules. This is the case even though the creditors may not have owned any shares in the bankrupt target.

Accordingly, many inversion traps still remain.

Avoiding Inversion Traps

The finalization of these inversion Regulations, coupled with the warnings provided by the IRS in the preamble, help illuminate the outer limits of the inversion rules. As such, they are important developments for Canadian corporations wishing to implement cross-border acquisitions and restructurings without triggering potentially very serious U.S. tax consequences. However, the inversion Regulations remain replete with technical rules and exceptions that create the potential for inadvertent inversions. Accordingly, Canadian companies should approach cross-border transactions with some caution and involve their U.S. tax advisors at the earliest structuring or restructuring stages to prevent unfortunate surprises.

U.S Tax (IRS Circular 230): Nothing in this communication (including in any attachment) is U.S. tax or other legal advice that is intended or written to be used, and it cannot be used, by any person to (i) avoid penalties under U.S. federal, state or local tax law, or (ii) promote, market or recommend to any person any transaction or matter addressed herein.

Paul Seraganian is a partner in the Tax Department of the firm's New York office. Michael H. Radolinski is an associate in the Tax Department in the firm's New York office.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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