A highly anticipated notice issued on Sept. 22 by the Treasury Department on tax inversion transactions may adversely affect the economics of such deals. Accordingly, parties considering such a transaction should carefully evaluate whether Treasury's new rules make it worth pursuing.

The issue of tax inversions – whereby a U.S. corporation is replaced by a foreign corporation as the parent company of a worldwide affiliated group of companies – has been the focus of both legislators and the administration. Section 7874 deals with a foreign acquiring corporation's treatment as a domestic corporation if certain conditions are met.

Recently, several legislative and administration proposals have focused on tightening the rules related to inversions after numerous large U.S. corporations announced they were either undertaking or were considering undertaking inversion transactions. As Congress debates what type of legislative action may be appropriate, Treasury has acted to make inversions less attractive by issuing Notice 2014-52. The notice not only tightens the application of Section 7874 to inversion transactions but also makes postinversion planning more difficult.

The notice states that certain recent inversion transactions are inconsistent with the purpose of current law, especially sections of the code that deal with inversion transactions, like Section 7874.

In light of concerns that "certain inversion transactions are motivated in substantial part by the ability to engage in certain tax avoidance transactions after the inversion that would not be possible in the absence of the inversion," Treasury, in Notice 2014-52, announced it intended to issue regulations under Sections 304(b)(5)(B), 367, 956(e), and 7701(l) to address postinversion transactions.

Any U.S. company considering an inversion should carefully examine whether Treasury's notice substantially affects the economics of their situation.

Furthermore, Treasury intends to issue future administrative guidance on inversions. This could affect other areas of international and corporate tax law, including intragroup loans resulting in earnings stripping under Section 163(j).

The rules described in the notice generally apply to transactions/acquisitions closing on or after Sept. 22, 2014 (with an ability for taxpayers to apply rules relating to subsequent transfers of stock of the foreign acquiring corporation when a domestic entity is a member of a foreign-parented group to acquisitions completed before Sept. 22, 2014).

Rules Under Section 7874 Relating To Inversion Transactions

Under Section 7874, certain adverse tax consequences can arise if a domestic corporation expatriates to a foreign jurisdiction, by way of acquisition by a foreign acquiring corporation.

Section 7874 generally applies if, as a part of plan or series of related transactions, three tests are met:

1. Substantially all of the assets of the domestic corporation are acquired directly or indirectly by the foreign acquiring corporation

2. At least 60% of the foreign corporation's stock (by vote or value) is held by the former shareholders of the domestic corporation, by reason of those shareholders' ownership in the domestic corporation

3. After the acquisition, the expanded affiliated group that includes the foreign acquiring corporation does not have substantial business activities in the jurisdiction where the foreign acquiring corporation is created or organized

If the percentage of ownership by the former shareholders of the domestic corporation is at least 60% but less than 80% and the other two tests are satisfied, certain adverse tax consequences can occur. If, however, the ownership by the former shareholders of the domestic corporation is 80% or more and the other two tests are satisfied, the foreign acquiring corporation will be treated as a domestic corporation.

Section 7874 also can apply in the context of a foreign corporation that acquires substantially all of the properties constituting a trade or business of a domestic partnership, assuming the ownership and substantial business activities tests of Section 7874 are satisfied.

To tighten Section 7874, the notice disregards a portion of the stock of a foreign acquiring corporation that holds a significant amount of passive assets. When rules of the notice are applied, Section 7874 would be more likely to apply to the transaction (as well as making it more likely that the 80% threshold to treat a foreign acquiring corporation as a domestic corporation will apply).

Additionally, the notice contains a rule that would prevent domestic entities from reducing their size by making certain "non-ordinary course distributions." The notice provides details on this calculation. Those so-called "skinny-down" distributions would be disregarded for purposes of calculating the ownership fraction under Section 7874 (thus, increasing the interest in the foreign acquiring corporation by the former owners of the domestic entity for purposes of the ownership test under Section 7874).

The notice also contains a similar rule for applying Treas. Reg. 1.367(a)-3(c) – a regulation dealing with outbound transfers of stock and securities – for purposes of applying the substantiality test in that regulation (a test for determining whether the foreign acquiring corporation is at least equal to the fair market value of the domestic target corporation).

The notice also contains detailed rules under Section 7874 regarding how Section 7874 should be applied when there are subsequent transfers of stock of the foreign acquiring corporation, with specific rules aimed at subsequent transfers involve a U.S.-parented group and at those involving a foreign-parented group. One of the transactions addressed by these rules would be the use of spinoffs to effect an inversion.

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.

'Anti-Hopscotch' Rules

If the controlled foreign corporation (CFC) makes a loan to its U.S. parent or acquires its U.S. parent's stock, holding such an obligation or stock generally would result in an investment in U.S. property under Section 956 with a possible income inclusion to the U.S. parent under Section 951.

The notice addresses certain transactions in which a CFC that is owned by an inverted U.S. company makes a loan to or invests in stock of the ultimate foreign parent of the group (or certain foreign related persons).

Relying on its authority under Section 956(e), the notice expands the definition of U.S. property in this situation by treating a CFC as holding "U.S. property" for purposes of Section 956. As a result, depending on the particular facts, the inverted domestic company could have an income inclusion under Sections 951 and 956.

'Decontrolling' Transactions

The notice also addresses certain types of transactions by the foreign parent or a foreign affiliate that are designed to "decontrol" a CFC. Treasury exercises its authority under Section 7701(l) to pursue that action.

One type of decontrolling strategy identified is when the new foreign parent of the group will buy enough stock in a CFC to take control of that entity away from the domestic company such that the foreign corporation is no longer a CFC. The notice states that the foreign parent would be treated as owning stock in the U.S. parent, rather than the CFC. The CFC would remain a CFC.

The notice also contains rules under Section 367(b) designed to modify the application of the Section 367(b) regulations to require an income inclusion in certain nonrecognition transactions that dilute a U.S. shareholder's ownership of a CFC.

Regulations To Prevent Removal Of Untaxed Foreign Earnings

In some cases, taxpayers may engage in certain transactions that could reduce the earnings and profits (E&P) of a CFC. One example in the notice is when after an inversion, the foreign acquiring corporation sells a portion of the U.S. target corporation's stock to a wholly owned CFC of the domestic corporation. In exchange, the foreign acquiring corporation receives property from the CFC. Some taxpayers have interpreted Section 304(b)(5)(B) to not apply where more than 50% of the dividend arising upon the application of Section 304 is sourced from the domestic company, even though, for example, pursuant to an income tax treaty there may be no (or a reduced rate of) U.S. withholding tax imposed on a dividend sourced from the domestic company. Under this position, the dividend sourced from the E&P of the CFC would never be subject to U.S. tax.

The notice states that regulations will provide that, for purposes of applying Section 304(b)(5)(B), the determination of whether more than 50% of the dividends that arise under Section 304(b)(2) is subject to tax or includible in the E&P of a CFC will be made by taking into account only the E&P of the acquiring corporation (and therefore excluding the E&P of the issuing corporation).

The notice also indicates these rules will apply as a general matter, regardless of whether an inversion transaction has occurred.

Request For Comments And Future Guidance

The notice says the Treasury Department expects to issue additional guidance to further limit inversion transactions that are contrary to the purposes of Section 7874 and the benefits of postinversion tax avoidance transactions. In particular, Treasury is considering guidance to address strategies that avoid U.S. tax on U.S. operations by shifting or "stripping" U.S.-source earnings to lower-tax jurisdictions, including through intercompany debt. The notice indicated that future guidance will apply prospectively; however, Treasury expects that to the extent any tax avoidance guidance applies only to inverted groups, such guidance will apply to groups that completed inversion transactions on or after Sept. 22, 2014.

The notice also stated that Treasury is reviewing its tax treaty policy regarding inverted groups and the extent to which taxpayers inappropriately obtain tax treaty benefits that reduce U.S. withholding taxes on U.S. source income.

The Takeaway

Treasury's actions are significant and taxpayers and their advisers should carefully study them. Taxpayers considering an inversion should take into account their own facts and circumstances and determine whether the transaction is still worth pursuing.

Action On Capitol Hill

With Congress not returning until after the Nov. 4 elections, there can be no legislative action on inversions in the next several weeks. It remains to be seen whether Congress will even take up the issue when it returns for the lame-duck session this fall.

Republicans have generally panned the approach of administrative rulemaking by Treasury, calling for fundamental tax reform versus stopgap measures.

Democrats, on the other hand, have supported administrative action, though for many, tax reform would be the ideal venue to address such transactions. Treasury Secretary Jacob Lew agrees with that approach and said that regulatory action can only affect some of the economics of inversion transactions, and that "only a change in law can shut the door, and only tax reform can solve the problems in our tax code that leads to inversions."

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.