The Treasury and IRS recently issued final regulations (T.D. 9834) (the “Final Regulations”) addressing inversion transactions that are structured to avoid the purposes of sections 7874 and 367 or utilize post-inversion earnings stripping strategies. The final regulations mostly follow the 2016 proposed regulations (T.D. 9761) which largely put a stop to most planned inversion transactions. A discussion of the impact of the 2016 proposed regulations can be found here. While the Tax Cuts and Jobs Act (TCJA) contained several anti-inversion provisions, the final anti-inversion regulations still serve as an important limitation on potential inversion transactions. Below are a few of the key takeaways.
Calculation of the ownership percentage
A U.S. corporation (or business) that engages in an inversion transaction may be subject to various adverse tax consequences. For example, a U.S. corporation that migrates offshore by becoming a foreign corporation must pay tax in the U.S. as if it were still a domestic U.S. corporation (and pay foreign tax as well). An inversion occurs where a foreign corporation acquires substantially all of the assets of a U.S. corporation and at least 60 percent of the shares of the foreign corporation are held by former shareholders of the U.S. corporation (the “ownership fraction”), and certain other requirements are met. The Final Regulations make several key technical modifications to the calculation of the ownership percentage. First, under the proposed regulations a special rule governing the treatment of passive assets operated to exclude from the denominator of the ownership fraction stock of the foreign acquiring corporation attributable to certain passive assets. This test was used for determining both the ownership percentage by vote and value. However, due to potential administrative complexities the final regulations only apply the passive assets rule for purposes of determining the ownership percentage by value. The final regulations additionally modify the passive assets rule to take into account other stock exclusion rules, for example, stock disregarded because it is attributable to serial acquisitions or third-country transactions.
Serial acquisition rule
The serial acquisition rule effectively disregards certain prior acquisitions by the foreign acquiring corporation for purposes of the ownership percentage. The preamble to the final regulations provides three technical clarifications. First, the determination of stock of the foreign acquiring corporation attributable to a prior US acquisition does not take into account stock that has been deemed to have been received. Second, the term domestic entity acquisition does not include a domestic acquisition that occurred as a part of certain internal group restructurings. Third, final regulations define a predecessor of a foreign acquiring corporation for purposes of the serial acquisition rule; previously the term had not been defined.
The third-country rule
The third-country rule excludes stock of the foreign acquiring corporation from the ownership calculation when a domestic entity acquisition is considered a “third country transaction.” These are transactions in which the foreign acquiring corporation participated in a “covered foreign acquisition,” which established tax residency for the foreign acquiring entity in a third-country. The final regulations provide that this rule will generally not apply when the foreign acquiring corporation has substantial business in such third-country or both foreign countries in question do not impose a corporate income tax.
The Final Regulations make several clarifications to the rules governing non-ordinary course distributions and how to account for them for purposes of the stock ownership tests in order to address public comments. Clarifications range from confirming that valid section 355 transaction distributions are not excluded under the rule to how to account for multiple foreign acquiring corporations competing for a single domestic entity corporation. In addition, deemed distributions resulting from shifts in partnership liabilities generally will not be treated as a distribution for purposes of these rules.
The Final Regulations also restrict certain exceptions to the special rules that require taxpayers to recognize income when they are shareholders in controlled foreign corporations that invest in U.S. property. Taxpayers with intercompany loans should carefully analyze these rules to determine whether they will be adversely impacted.
The final regulations have a general effective date of April 4, 2016. Taxpayers engaging in international restructurings that may be considered inversion transactions should review the modifications made by the Final Regulations to determine how they may be impacted.