Keywords: IRS, Treasury Department, inversion transactions

Following weeks of anticipation and speculation about administrative guidance on corporate inversions, the Internal Revenue Service ("IRS") and the Treasury Department ("Treasury") released Notice 2014-52 ("Notice") on September 22, 2014, describing new regulations to be issued by the government to curtail inversion transactions.

The Notice introduces two new sets of rules: (1) rules to prevent taxpayers from avoiding the application of Internal Revenue Code ("Code") sections 7874 and 367 (described below under "New Regulations to Prevent Avoidance of Code Sections 7874 and 367") and (2) rules seeking to reduce or neutralize perceived tax benefits that may be available to inverted corporations (described below under "Regulations to Address Post-Inversion Transactions").


Code section 7874 applies when, pursuant to a plan or a series of related transactions:

  1. a foreign corporation acquires (directly or indirectly) substantially all of the properties held directly or indirectly by a domestic corporation (or substantially all of the properties constituting a trade or business of a domestic partnership);
  2. at least 60% of the stock (by vote or value) of the foreign acquiring corporation is held by the former shareholders of the domestic corporation (or by the former partners of the domestic partnership) by reason of holding stock in such domestic corporation (or holding an interest in such domestic partnership) (the "Ownership Test"); and
  3. the expanded affiliated group which includes the foreign acquiring corporation does not have "substantial business activities" in the foreign country in which the entity is organized, when compared to the total business activities of the group.

If these three prongs are met, the following adverse tax consequences result: (a) if the former shareholders or partners of the domestic entity hold at least 60%, but less than 80%, of the stock of the foreign acquiring corporation, then the domestic acquired entity is limited in its ability to use certain tax attributes and (b) more drastically, if the former shareholders or partners of the domestic entity hold 80% or more of the stock of the foreign acquiring corporation, the foreign acquiring corporation is treated as a domestic corporation for all US income tax purposes (thereby likely thwarting tax benefits sought for such transaction).

The first set of rules introduced by the Notice addresses certain techniques through which taxpayers are perceived to manipulate the Ownership Test in order to avoid the application of Code section 7874 (and, to a certain extent, Code section 367). The second set of rules, in turn, applies to certain transactions taking place after an inversion covered by Code section 7874 has already occurred (the rules would apply if the Ownership Test is satisfied with at least 60%).

New Regulations to Prevent Avoidance of Code Sections 7874 and 367


Treasury and the IRS are concerned that certain taxpayers engaging in inversion transactions are looking for ways to inflate the size of the foreign acquiring corporation to ensure that their transaction does not surpass the 80% threshold of the Ownership Test. In particular, the government believes that some taxpayers are seeking "old and cold" foreign companies with cash and other passive assets as merger partners so as to decrease the ownership fraction for purposes of the Code section 7874 analysis.

To the extent cash or marketable securities are contributed to the foreign acquiring corporation "in a transaction related to the acquisition," the stock issued in exchange for such "nonqualified property" would be disregarded under the current Code section 7874 regulations. If, however, the nonqualified property was not acquired by the foreign corporation in a transaction related to the acquisition, the stock attributable to the nonqualified property would not be disregarded, thus reducing the Code section 7874 ownership fraction. The Notice intends to tackle this issue of US taxpayers seeking "old and cold cash boxes" as foreign merger partners.

The Notice provides that if, after the acquisition, at least 50% of the assets of the foreign acquiring corporation's expanded affiliated group (excluding assets directly or indirectly held by the domestic entity at the time of the acquisition) constitute "foreign group nonqualified property," an amount of stock proportionate to the group's percentage of "foreign group nonqualified property" will be disregarded for purposes of the Code section 7874 Ownership Test. "Foreign group nonqualified property" is generally defined to include the different types of "nonqualified property" under the current Code section 7874 regulations, with exceptions to prevent the application of this new rule to certain financial institutions.


Another way in which a taxpayer may seek to reduce the Code section 7874 Ownership Test percentage is by distributing an extraordinary dividend prior to the inversion transaction, thus reducing the size of the acquired domestic entity. Similarly, the distribution of these extraordinary dividends may allow the Code section 367(a) shareholder-level tax upon the inversion transaction to be avoided by reason of the satisfaction of the "substantiality test" (i.e., the fair market value of the transferee foreign corporation is at least equal to the fair market value of the US target company).

To address these perceived tax avoidance transactions, the Notice provides that all "nonordinary course distributions" made by the domestic acquired entity during the 36-month period ending on the acquisition date will be disregarded for Code section 7874 purposes.

A "non-ordinary course distribution" is defined as the excess of all distributions made by the domestic entity during a taxable year over 110% of the average of such distributions during the 36-month period immediately preceding such taxable year. The rule applies to any "distribution" regardless of whether it is treated as a dividend (e.g., if the inversion acquisition qualifies as a reorganization under Code section 368(a), any "boot" received by the former shareholders of the domestic entity would be subject to the "nonordinary course distribution" rule).

The Notice indicates that Code section 367(a) regulations will also be modified to include a rule that incorporates these same principles in the context of the "substantiality test."


Interestingly, the Notice also introduces a new rule mainly intended to address so-called "spinversion" transactions, where a US Parent transfers a portion of its assets (e.g., all the stock of a Domestic Sub) to a newly formed Foreign Co and then spins off Foreign Co to its public shareholders.

Under the existing Code section 7874 regulations, taxpayers may attempt to structure this type of transaction by relying on the so-called "internal group restructuring exception."Under this exception, if Domestic Sub and Foreign Co are members of an affiliated group with the same common parent before and after the transaction (i.e., US Parent), stock of Foreign Co held by members of the expanded affiliated group would be excluded from the numerator but not from the denominator of the Ownership Test fraction. In the transaction addressed in the Notice, stock of Foreign Co would have been held by US Parent (a member of the expanded affiliated group) after the transfer of Domestic sub to Foreign Co. In this regard, it should also be noted that the current Code section 7874 regulations specifically provide that any distribution or transfer of the foreign acquiring corporation's stock occurring after the inversion transaction ought to be disregarded for purposes of the Ownership Test, even if such transfer or distribution is related to the inversion.

The Notice changes this result. Under the Notice, stock of the foreign acquiring corporation that is received by a former corporate shareholder of the acquired domestic entity and is subsequently transferred in a transaction related to the acquisition is not treated as held by a member of the expanded affiliated group and, as such, is included in both the numerator and the denominator of the ownership fraction. As a result, Foreign Co would not benefit from the internal group restructuring exception and would be treated as a domestic corporation under Code section 7874. The Notice outlines certain exceptions to this new rule.

Regulations to Address Post-Inversion Transactions


Under Code section 956, an investment in US property by a controlled foreign corporation ("CFC") (e.g., through a loan to a US parent or affiliate or an equity investment in a US affiliate) is taxable to the CFC's US shareholders on the basis that the loan represents a repatriation of the CFC's earnings and profits without the distribution of a dividend.

The IRS and Treasury believe that an inversion transaction may allow taxpayers to sidestep Code section 956 by accessing CFC untaxed earnings and profits without current US taxation. This could be achieved, for example, by having a CFC make a "hopscotch" loan to the new foreign parent (not a CFC) or to another non-CFC foreign affiliate that could then, eventually, on-lend the money to the former US parent. Technically, this would not have triggered current taxation under Code section 956 because there was no loan from a CFC to a US entity.

To address this issue, the Notice expands the concept of "US property" for Code section 956 purposes. Pursuant to the Notice, any obligation or stock of a foreign person related to the expatriated entity will be treated as US property to the extent such obligation or stock is acquired by a CFC of the expatriated entity within the 10- year period after the inversion. As a result of this construct, a loan by the CFC to a non-CFC-related person would be treated as if the CFC had made a loan to its US parent prior to the inversion and thus could result in a Code section 956 inclusion.


Treasury and the IRS also voiced concerns that an inverted group may, through tax-free transactions, cause the foreign subsidiaries of the expatriated entity to cease to be CFCs, thus allowing tax-free access to their pre-inversion earnings and profits. For example, the foreign acquiring corporation may make an equity investment in a CFC for stock representing at least 50% of the foreign subsidiary's voting power and value, causing the foreign subsidiary to lose its CFC status. Once a foreign subsidiary has lost its CFC status, it could make its preinversion earnings and profits available to the US shareholders without triggering an income inclusion under Code section 956.

To tackle this issue, the Notice provides that, during the 10-year period after the inversion, transfers or new issuances of stock of a foreign subsidiary of the US corporation to a foreign affiliate that is not itself controlled by the US corporation will generally be recharacterized as if: (i) the property was transferred by the uncontrolled foreign affiliate to the US corporation in exchange for an instrument deemed to have been issued by the US corporation and (ii) the US corporation contributed the property to the expatriated foreign subsidiary in exchange for stock of the expatriated foreign subsidiary. Under this recharacterization, the "decontrol" strategy would have been ineffective and the expatriated foreign subsidiary would remain a CFC due to the shareholding constructively retained by the US corporation.


According to the Notice, taxpayers may be engaging in certain post-inversion transactions in which the new foreign parent sells a portion of the stock of the acquired domestic corporation to one of the domestic corporation's wholly owned CFCs in exchange for cash or property. This related-party sale would be subject to Code section 304(a)(2). The Notice indicates that taxpayers may be taking the position that, under Code section 304(b)(5)(B), the transaction would give rise to a dividend from the CFC subsidiary directly to the foreign parent to the extent more than 50% of the Code section 304 deemed dividend is sourced from the domestic corporation.

To address these transactions, the Notice provides that the determination under Code section 304(b)(5)(B) of whether more than 50% of the Code section 304 deemed dividend is subject to tax or includable in the earnings and profits of a CFC will be made by taking into account only the earnings and profits of the acquiring corporation (i.e., excluding the earnings and profits of the issuing corporation).

It is worth noting that this rule applies as a general matter, regardless of whether an inversion transaction has occurred.

Effective Dates and Further Guidance

The regulations relating to Code section 304 described above would apply to acquisitions of stock described in Code section 304 completed on or after September 22, 2014. With respect to all of the other rules described in the Notice, the regulations to be issued would only apply to inversions where the acquisition of the properties of the domestic entity was completed on or after September 22, 2014.

The Notice indicates that Treasury and the IRS expect to issue additional guidance to further limit inversion transactions. In particular, the Notice raises the prospect of guidance relating to earnings stripping through the use of intercompany debt. Further, the Notice forewarns that it is to be expected that any such future guidance will apply to groups that completed inversions on or after September 22, 2014.

In addition to the prospect of further administrative guidance, our government practice group believes that there are some prospects for legislative activity around inversion transactions during the "Lame Duck" session in December. This will depend, in their view, on whether Democrats maintain control of the Senate. If Democrats maintain the majority, there is a higher probability the Lame Duck Congress will attempt to address corporate inversions.

If Congress remains divided in January, the pairing of Senate Finance Chairman, Ron Wyden, and likely House Ways and Means Chairman, Paul Ryan, could certainly create the dynamics for a comprehensive tax reform initiative. Both Wyden and Ryan are widely known as thought leaders who have the capacity to delve into the complicated details needed to put together such a tax reform package.

Although the Notice did not address earnings stripping, eliminating certain interest deductions remains popular amongst key lawmakers on Capitol Hill. Therefore, at this time, it is likely to be part of the negotiations.

Early and effective advocacy on this issue is critical.

Originally published 25 September 2014

Learn more about our Tax Transactions & Consulting, Tax Controversy, Corporate & Securities and Government Relations practices.

Visit us at

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2014. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.