On April 4, 2016, the U.S. Treasury Department released two significant packages of U.S. federal tax regulations. T.D. 9761 contains temporary regulations primarily addressing the anti-inversion rules under section 7874 of the Internal Revenue Code, and REG-108060-15 contains proposed anti-earnings stripping regulations that apply generally to related-party debt. Descriptions of the new rules are set forth below.
Temporary Anti-Inversion Regulations
These regulations primarily implement the rules first described
by Treasury in Notices 2014-52 and 2015-79 (the
"Notices") but also introduce certain new rules and
modifications to existing rules that have not been described in any
prior guidance.
Under section 7874 generally, a foreign acquiring corporation is
treated as a U.S. corporation for U.S. tax purposes if it acquires
substantially all of the stock (or property) of a U.S. target
corporation and the shareholders of the U.S. target corporation own
at least 80 percent of the foreign acquiror stock after the
exchange. Although a foreign acquiring corporation remains a
foreign corporation for U.S. tax purposes when the U.S. target
corporation's shareholders receive less than 80 percent of the
foreign acquiring corporation stock in the exchange, section 7874
denies the U.S. corporation use of certain tax attributes when the
shareholders of the U.S. target corporation own at least 60
percent, but less than 80 percent, of the foreign acquiror stock
after the exchange.
Implementation of Rules Introduced in Notices 2014-52 and
2015-79. The regulations implement the rules introduced in
the Notices, which (i) increase the likelihood that in an
acquisition of a U.S. corporation by a foreign acquiring
corporation, the shareholders of the U.S. corporation will meet or
exceed the 60 percent or 80 percent thresholds, invoking the
putative rules of section 7874, and (ii) decrease the tax planning
that can be undertaken after a 60 percent inversion. Specifically,
the regulations include the following.
Rules from Notice 2014-52: For purposes
of determining whether the 60 percent and 80 percent tests are
satisfied–
- Decreasing the relative size of a foreign acquiring corporation for purposes of calculating the ownership fraction if such foreign acquiring corporation holds a significant amount of passive assets;
- Ignoring certain distributions made by the U.S. corporation during the 36 months preceding an inversion; and
- Subjecting certain types of multistep spin-offs (so-called "spinversions") to section 7874;
For purposes of preventing the U.S. corporation from using the tax benefits resulting from an inversion–
- Treating related-party foreign-to-foreign "hopscotch" loans as investments in U.S. property subject to current U.S. tax;
- Preventing the tax-free decontrolling of a controlled foreign corporation; and
- Prohibiting certain related-party stock sales from being used to strip the earnings of a controlled foreign corporation.
Rules first introduced in Notice 2014-52 that were implemented by
the temporary regulations without substantive change are effective
for transactions completed on or after September 22, 2014.
Rules from Notice 2015-79:
- Denying the exception to section 7874 for "substantial business activities," unless the foreign acquiring corporation's group has substantial business activities in the country where its parent is tax resident;
- Treating what would otherwise be a 60 percent inversion as a per se 80 percent inversion if a foreign corporation and U.S. corporation are each acquired by a new foreign acquiring corporation organized in a third country; and
- Treating "indirect" transfers of property by a U.S. corporation after a 60 percent inversion as if directly made by the U.S. corporation for U.S. tax purposes.
Rules first introduced in Notice 2015-79 that were implemented by
the temporary regulations without substantive change are effective
for transactions completed on or after November 19, 2015.
New Anti-Inversion Rules. In addition to
implementing the rules described in the Notices, the temporary
regulations also introduce new rules not contained in any prior
guidance as well as substantive modifications to the rules in the
Notices. These new rules and modifications to the Notices are
effective for transactions completed on or after April 4,
2016.
Chief among the new rules is the so-called "serial
inverter" rule. For purposes of calculating the inversion
ownership fraction with respect to a new acquisition, this rule
generally disregards foreign acquiring corporation stock issued (or
deemed issued) in those acquisitions of U.S. corporations occurring
within the 36-month period ending on the date a new acquisition
becomes subject to a binding contract. These regulations contain an
anti-avoidance rule that disregards the termination of an existing
contract signed within this 36-month period when the parties to
that terminated contract enter into a substantially similar
contract outside the 36-month period. This serial inverter rule has
the effect of increasing the likelihood that the foreign company
shares issued in the new acquisition to the U.S. corporation
shareholders will represent 60 percent (and maybe 80 percent) of
the adjusted number of outstanding shares of foreign acquiring
corporation stock, thus increasing the likelihood that the new
acquisition will be subject to the putative rules of section
7874.
For example, assume that foreign Company A is worth $100 in Year 0.
In Year 1, Company A acquires U.S. Company B in exchange for $50 of
Company A stock. In Year 2, Company A acquires U.S. Company C in
exchange for another $50 of Company A stock. Finally, in Year 3,
Company A acquires U.S. Company D in exchange for $150 of Company A
stock. Absent the serial inverter rule, the Company D shareholders
would own $150/$350 or 43 percent of the Company A stock
post-inversion. Under the serial inverter rule, Company A's
acquisitions of Company B and Company C stock are disregarded when
determining whether the Company D acquisition is a 60 percent or 80
percent inversion. As a result, Company A is treated as if it were
worth $100 before the acquisition of Company D, and Company D's
shareholders are deemed to own $150/$250 or 60 percent of Company A
after the transaction, resulting in a 60 percent inversion.
These regulations are temporary and will sunset on April 4, 2019,
although it is generally the case that final regulations are issued
before a temporary regulation sunsets.
Proposed Earnings Stripping Regulations
In the Notices, Treasury also notified taxpayers that it was
considering the issuance of anti-earnings stripping rules to
prevent perceived unwarranted base erosion. One of the purposes of
an anti-earnings stripping rule is to prevent U.S. companies from
shifting income from high-tax to low-tax jurisdictions through the
issuance of debt between related companies (i.e., where the
interest on the debt would generate a tax deduction offsetting
income taxed at a high rate but would be taxed in a different
jurisdiction with a lower rate). These proposed regulations contain
those rules, but in a more expansive manner than expected. As
drafted, the proposed regulations, issued under the authority of
section 385, are not limited to merely earnings stripping
arrangements. The regulations apply to a much broader set of
related-party transactions. For example, the proposed regulations
are applicable to the treatment of debt between both U.S.-to-U.S.
related parties (except members of a U.S. consolidated group) as
well as U.S.-to-foreign related parties.
Specifically, the proposed regulations (i) require certain
related-party debt to be treated as stock of the issuer, (ii)
enable the IRS to treat certain related-party debt as partially
equity, and (iii) specify due diligence and documentation that must
be undertaken and maintained in order for certain related-party
debt to be respected as debt for U.S. tax purposes. The effect of
the application of these rules would be the denial of any interest
deduction taken with respect to recharacterized debt and the
recharacterization of payments made on the debt as distributions on
stock (potentially treated as dividends for U.S. tax
purposes).
The application of the proposed regulations is limited to debts
between members of a group (referred to in the regulations as
"expanded groups"), which generally include all
corporations (foreign and domestic) related through direct, or
indirect, stock ownership of 80 percent of the voting power or
value. The regulations do not apply, however, to debts directly
between members of a U.S. consolidated group.
Recharacterization of Debt Rules. Under the
proposed regulations, intercompany debt can be recharacterized as
stock if it is issued (i) as a distribution from one expanded group
member to another, (ii) as consideration by one expanded group
member for the stock of another, or (iii) as boot in certain
intergroup reorganizations. Additionally, intercompany debt may be
recharacterized as stock when issued with a principal purpose of
funding a distribution or acquisition by the funded member,
regardless of whether the lending member is a party to such
distribution or acquisition. A principal purpose of funding the
distribution or acquisition is generally presumed, on a
nonrebuttable basis, if the debt in question was issued within 36
months of the distribution or acquisition, subject to a limited
exception for debt issued in the ordinary course of certain trade
or business activities.
Not all intercompany debt is subject to recharacterization. As
mentioned above, debt directly between U.S. consolidated group
members is exempt from these rules. Debt distributed by a member is
not recharacterized as stock to the extent of the issuer's
current year earnings and profits. These rules do not apply to
expanded groups if the aggregate issue price of all the expanded
group's debt subject to these rules does not exceed $50
million. These recharacterization rules are generally applicable to
debt instruments issued on or after April 4, 2016. However, such
instruments will continue to be treated as debt until 90 days after
the finalization of the proposed regulations, at which time such
debt instruments, if outstanding and subject to the
recharacterization rule, will be treated as exchanged for stock for
U.S. tax purposes. The regulations attempt to prevent some of the
negative tax consequences of the deemed exchange, such as
preventing cancellation of indebtedness income for the debtor and
recognition of gain or loss by the creditor.
Bifurcation Rules. The proposed regulations also
enable the IRS (and not the taxpayer) to bifurcate a related-party
debt instrument, treating it as partially debt and partially equity
where the facts support partial equity treatment. These bifurcation
rules, however, apply to "modified expanded groups" by
lowering the ownership threshold from 80 percent to 50 percent.
These bifurcation rules are generally applicable to debt
instruments issued on or after the date that these rules become
final.
Documentation Requirements. The proposed
regulations also prescribe rules requiring documentation and
information that must be prepared and maintained in connection with
the issuance of related-party debt between members of expanded
groups in order for such debt to be respected as debt for U.S. tax
purposes. Generally, the proposed regulations require that such
documentation must evidence (i) the legally binding obligation to
pay, (ii) the creditor's right to enforce, (iii) the reasonable
expectation of repayment, and (iv) an ongoing arm's-length
debtor–creditor relationship during the life of the debt. The
proposed regulations require that the documentation be prepared no
later than 30 days after the date the debt is issued, except for
documentation of the debtor–creditor relationship, which must
be prepared within 120 days after the date the debt is
issued.
These documentation rules apply to expanded groups that include a
member that is publicly traded or have assets in excess of $100
million or annual revenue in excess of $50 million. The rules also
provide relief for taxpayers that fail to comply, if such failure
is due to reasonable cause. These documentation rules are generally
applicable to debt instruments issued on or after the date that
these rules become final.
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.