Inversion May Be More Difficult to Avoid
On June 7, 2012, the U.S. Treasury issued revised final and temporary regulations under U.S. Internal Revenue Code of 1986, as amended (Code), § 7874, which governs treatment of certain “inversion transactions” whereby foreign corporations acquire substantially all of the properties held by a domestic corporation (or substantially all of the properties constituting a trade or business of a domestic partnership).
Generally, under Code § 7874, a domestic corporation or partnership (an “expatriated entity”) acquired by a foreign corporation (a “surrogate foreign corporation”), where at least 60% of the stock of the surrogate foreign corporation will be held by former shareholders of the expatriated entity, is subject to tax on its “inversion gain” (i.e., its income or gain recognized by reason of its transfer of stock or other properties, and certain of its income received or accrued by reason of a license of property, as part of the inversion transaction). Where at least 80% of the stock of the surrogate foreign corporation is held by former shareholders of the expatriated entity, the surrogate foreign corporation will be treated for U.S. federal tax purposes as a domestic corporation (i.e., an “inverted corporation”).
These rules do not apply if after the acquisition, the “expanded affiliated group” (EAG) that includes the surrogate foreign corporation has substantial business activities in the foreign country in which, or under the laws of which, the entity is created or organized, when compared to the total business activities of the EAG.
In 2006, then-temporary regulations provided a facts and circumstances test for analyzing substantial business activities, but also provided a safe harbor whereby the EAG was considered to have the requisite substantial business activities if, after the acquisition, the group employees based in the foreign country accounted for at least 10% (by headcount and compensation) of total group employees, the total value of the group assets located in the foreign country was at least 10% of the total value of all group assets, and the group sales made in the foreign country during the relevant testing period accounted for at least 10% of total group sales.
In 2009, these regulations were modified to eliminate the safe harbor rule while keeping the general facts and circumstances test, listing certain items to be taken into account (e.g., the historical conduct of continuous business activities in the foreign country by the EAG and the performance in the foreign country of substantial managerial activities by officers and employees of the EAG based in the foreign country) or ignored (e.g., assets, business activities, or employees located in a foreign country at any time as part of a plan with a principal purpose of avoiding the purposes of Code § 7874) for purposes of the analysis.
The new regulations move the substantial business activities test to new temporary regulations (Regulations § 1.7874-3T), which build upon the safe harbor rules contained in the 2006 temporary regulations. Regulations § 1.7874-3T provides a hard and fast rule as to when the EAG will be considered to have substantial business activities in the relevant foreign country after the acquisition when compared to the total business activities of the EAG. Under the new temporary regulations, the substantial business activities test will be satisfied only if (1) the number of group employees based in the relevant foreign country is at least 25% of the total number of group employees on the applicable date and the employee compensation incurred with respect to group employees based in the relevant foreign country is at least 25% of the total employee compensation incurred with respect to all group employees during the testing period, (2) the value of the group assets located in the relevant foreign country is at least 25% of the total value of all group assets on the applicable date, and (3) the group income derived in the relevant foreign country is at least 25% of the total group income during the testing period. Items to be ignored in the numerator (but still taken into account in the denominator) are similar to those that appeared under the 2009 temporary regulations.
For purposes of the group asset test, a group asset is located in the relevant foreign country only if the asset was physically present in such country at the close of the acquisition date and for more time than in any other country during the one-year period ending on the applicable date. In addition, all group assets must be valued consistently and on a gross basis using either the adjusted tax basis or fair market value determined in U.S. dollars. Certain tangible personal property or real property that is rented by members of the EAG is treated as a group asset (and certain special valuation rules apply to group assets that are rented).
The term “applicable date” for purposes of these rules means either (applied consistently for all purposes of the inversion rules) the acquisition date or the last day of the month immediately preceding the month in which the acquisition is completed.
In addition, whereas the 2009 temporary regulations provided that a member of the EAG that holds at least a 10% capital and profits interest in a partnership takes into account its proportionate share of all the items of the partnership, the new temporary regulations provide that if one or more members of the EAG own, in the aggregate, more than 50% (by value) of the interests in a partnership, the partnership will be treated as a corporation that is a member of the EAG (and all items of such a partnership are taken into account for purposes of the substantial business activities test).
In addition to the foregoing, the new regulations (1) finalize without modification, other than updating the effective date, temporary regulations relating to the treatment of stock held by a partnership under Regulations § 1.7874-1 (regarding treatment of certain affiliate-owned stock in analyzing the 60% and 80% thresholds); (2) finalize, with modification, the temporary regulations relating to the determination of whether a foreign corporation is treated as a surrogate foreign corporation under Regulations § 1.7874-2 (and the treatment of options as stock); and (3) clarify that an acquisition by a corporation of its stock from another corporation or a partnership (i.e, a “downstream” transaction) is an acquisition of the transferor’s properties for purposes of the inversion rules, even though the acquired stock no longer exists after the transaction.
The new regulations are generally effective for acquisitions that are completed on or after June 7, 2012 (though the temporary regulations governing substantial business activities are set to expire on June 5, 2015).
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