The IRS has issued temporary and proposed regulations (T.D. 9592 and REG-107889-12) adopting a bright line test for determining whether a foreign corporation satisfies the substantial business activities test of Section 7874(a)(2)(B)(iii) to avoid treatment as an inverted corporation. The IRS also finalized regulations (T.D. 9591) under other areas of Section 7874.
The bright line test in the new temporary regulations replaces temporary regulations in 2009, which permitted the determination of whether an expanded affiliated group (EAG) has substantial business activities in the relevant foreign jurisdiction to be based on all the facts and circumstances.
Under the new temporary regulation, an EAG will have substantial business activities in the relevant foreign country only if at least 25 percent of each of the group employees, group assets and group income are located in or derived in the relevant foreign country, determined as follows:
- Group employees — Two tests must be met: (1) The number of employees of members of the EAG (group employees) based in the foreign jurisdiction must be at least 25 percent of the total number of group employees as of the applicable date; and (2) the employee compensation incurred with respect to the group employees based in the foreign jurisdiction must be at least 25 percent of the total employee compensation incurred with respect to all group employees during a one-year testing period.
- Group assets — At least 25 percent of the value of the EAG's assets (group assets) must be located in the relevant foreign jurisdiction. For this purpose, the term "group assets" generally means tangible personal property or real property used or held for use in the active conduct of a trade or business by members of the EAG.
- Group income — At least 25 percent of the EAG's income (group income) must be derived from the foreign jurisdiction during a one-year testing period. For this purpose, the term "group income" means gross income of members of the EAG from transactions occurring in the ordinary course of business with customers that are not related persons. Group income is considered to be derived in a foreign country only if the customer is located in such country.
Subject to a limited transition rule, the new temporary regulations generally apply to acquisitions completed on or after June 7, 2012.
The final regulations issued under Section 7874 largely adopt the rules in the prior 2009 proposed regulations (REG-112994-06) with some changes. For example, several changes relate to the treatment of options or similar interests for purposes of applying the ownership and acquisition tests of the statute, as well as for determining membership in an EAG. A new anti-abuse rule for options was added.
The final regulations also address downstream transactions and clarify that an acquisition by a corporation of its stock from another corporation or a partnership is an acquisition of the transferor's properties for purposes of Section 7874(a)(2)(B)(i). This rule applies even though, for federal tax purposes, the acquired stock no longer exists after the transaction. Thus, for example, if a domestic corporation with stock in a foreign corporation merges into the foreign corporation, the foreign corporation is treated for purposes of Section 7874(a)(2)(B)(i) as acquiring properties of the domestic corporation in the form of the foreign corporation's stock.
The final regulations apply to acquisitions completed on or after June 7, 2012.
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