The IRS has announced it will tighten its anti-inversion rules in Notice 2015-79, issued last week, through regulations which will address tax avoidance transactions at the time of, and post-inversion.
Internal Revenue Code section 7874 (Rules Relating To Expatriated Entities And Their Foreign Parents) contains the taxation rules for expatriated entities by way of inversion. Section 7874 was enacted in response to concerns by Congress that “inversion transactions resulting in minimal presence in a foreign country of incorporation are a means of avoiding U.S. tax and should be curtailed” – S.Rep. No. 192, 108th Cong., 1st Sess. 142 (Nov. 7, 2003).
Section 7874 does not apply if the foreign acquiring corporation has “substantial business activities” in the foreign country.
Under new regulations, a foreign acquiring corporation will be required to be subject to tax as a resident of the relevant foreign country in order to be deemed to have “substantial business activities” in the foreign country for section 7874 purposes.
Historically there has been more than one set of temporary regulations addressing the principle of “substantial business activities”, including a test related to the percentage of group employees based on the foreign country.
Other changes under the proposed regulations include:
- Expanded definition of ‘inversion gain’ for the purposes of section 7874, to include certain income or gain recognized by an expatriated entity from an indirect transfer or license of property, and provisions for the aggregate treatment of certain transfers or licenses of property by foreign partnerships for the purpose of determining inversion gain.
- A new definition of what is “nonqualified property” for the purposes of disregarding certain stock of the foreign acquiring corporation.
- An exchanging shareholder will be required to recognize all gain realized upon an exchange of stock of a controlled foreign corporation without regard to the amount of the CFC’s undistributed earnings and profits if the transaction terminates the status of the foreign subsidiary as a CFC or substantially dilutes the interest of a U.S. shareholder for CFC purposes.
An inversion for U.S. tax purposes is a takeover transaction involving a non-U.S. entity acquiring all of the stock or assets of a U.S. corporation. This has historically been a technique to remove the U.S. corporation from U.S. income tax and subject it to taxes in a lower taxing jurisdiction. The motives for this are that:
- U.S. corporations are subject to U.S. corporate taxes on worldwide income, whether derived from U.S. or non-U.S. operations, and
- The U.S. has the highest corporate tax rate in the world (39%), therefore credits for foreign taxes on offshore earnings are insufficient to offset the U.S. tax liability, resulting in U.S. tax payable.
The U.S. is one of the last countries in the world to impose a tax on worldwide earnings.
Notice 2015-79 states that transactions at issue and regulations to be issued are:
(a) Substantial Business Activities of a Foreign Acquiring Corporation that is not Subject to Tax as a resident of the Relevant Foreign Country
The Treasury Department and the RS are aware of transactions in which the taxpayer asserts that the EAG has substantial business activities in the relevant foreign country (that is, the foreign country in which, or under the law of which, the foreign acquiring corporation is created or organized) when compared to the EAG’s total business activities, but the foreign acquiring corporation is not subject to income taxation in the relevant foreign country as a resident. This could occur, for example, if the relevant foreign country determines the tax residency of an entity based on criteria other than the place of creation or formation, such as the location in which the entity is managed or controlled. If the foreign acquiring corporation is managed and controlled in a third country, the foreign acquiring corporation may not be subject to tax as a resident of the relevant foreign country (or, in some cases, of any foreign country).
Alternatively, the foreign acquiring corporation may not be subject to tax as a resident of the relevant foreign country because of disparate entity classification rules in the United States and the relevant foreign country. For example, the foreign acquiring corporation may be treated as a corporation for U.S. tax purposes under the entity classification regulations promulgated under section 7701 (including by reason of a “check the box” election), but as a fiscally transparent entity under the tax law of the relevant foreign country. In such a case, the foreign acquiring corporation would not be subject to tax as a resident of the relevant foreign country.
The Treasury Department and the IRS have determined that the policy underlying the exception to section 7874 when there are substantial business activities in the relevant foreign country is premised on the foreign acquiring corporation being subject to tax as a resident of the relevant foreign country (pp 5-6 Notice 2015-79).
The regulations become effective generally for acquisitions completed on or after 19 November 2015 – 23 November 2015.